This article originally appeared in the November 8, 2021, issue of Tax Notes Federal.
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Edward A. Zelinsky is the Morris and Annie Trachman Professor of Law at the Benjamin N. Cardozo School of Law of Yeshiva University.
In this article, Zelinsky argues that section 4968, which imposes an annual tax on the investment income of some college and university endowments, should remain in the tax code as a revenue measure and a harbinger of a world in which all charitable endowments pay annual tax on their investment incomes.
Tucked away in the massive legislation approved by the House Ways and Means Committee as H.R. 53761 (the Build Back Better Act (BBBA)) is that bill’s section 137702, which would amend IRC section 4968.2 Section 4968, adopted in 2017, imposes an annual tax on the investment incomes of some college and university endowments. Section 4968 is modeled on section 4940,3 which has levied a similar annual tax on the investment incomes of private foundations since 1969. If enacted, section 137702 of the BBBA would amend IRC section 4968 to abate the tax imposed by that section if an educational institution satisfies a proposed statutory formula for student scholarship aid.
Section 137702 would transform section 4968 from a revenue-raising tax like section 4940 into a regulatory measure. As a matter of tax policy, this is wrong. Section 4968 is an important step in the process of extending the IRC’s revenue-raising taxation of private foundations to other similar institutions. Section 137702’s modification of section 4968 would truncate the desirable process of extending to all charitable endowments the kind of revenue-generating tax imposed on private foundations by section 4940. All charitable endowments, including community foundations, educational endowments, and donor-advised funds, should make the same annual contribution to the federal treasury required of private foundations under section 4940.4 Section 4968 should be modified to extend its coverage to all educational endowments and, ultimately, to the universe of charitable endowments.
If Congress wants to regulate the scholarship practices of colleges and universities, it should adopt a separate regulatory tax in addition to section 4968. The IRC provides many examples of regulatory taxation. Section 4968 itself should remain in the code as it is today, a revenue measure and a harbinger of a world in which all charitable endowments would pay the same kind of annual tax on their investment incomes as private foundations pay under section 4940.
However well-meaning the advocates of the BBBA’s section 137702 may be, in IRC section 4968 they have picked the wrong vehicle for regulating college and university endowments.
The Private Foundation Excise Taxes
An analysis of section 137702 starts with the excise taxes levied on private foundations by the Tax Reform Act of 1969 (TRA 69). Except for the tax imposed on private foundations by section 4940, these excise taxes are regulatory measures, triggered when a private foundation fails to meet specified standards of behavior. Section 49415 taxes self-dealing transactions between private foundations and enumerated “disqualified person[s]” positioned to take advantage of the foundations’ assets. The evident purpose of section 4941 is to deter insiders from abusing the assets of private foundations, not to raise revenue. Absent a “disqualified person” transacting impermissibly with a private foundation’s resources, no tax is due under section 4941. The apparent function of section 4941 is to deter self-dealing, not to raise revenue.
Similarly regulatory in nature is section 4942.6 That section imposes penalty taxes if in any year a private foundation fails to distribute for charitable purposes an amount equal to 5 percent of the foundation’s assets. Like section 4941, section 4942 is not designed to raise revenue. Rather, section 4942 ensures that private foundations will distribute, rather than accumulate, their basic incomes. Any foundation that so distributes has no tax liability under section 4942.
Consider as well, section 4943,7 another regulatory tax added to the IRC as part of TRA 69’s package of excise taxes applying to private foundations. Section 4943 taxes a private foundation if that foundation has “excess business holdings.” Section 4943 thereby deters private foundations from owning large interests in businesses. Congress deemed those large interests inimical to the proper functioning of private foundations.8 A private foundation that eschews any “excess business holdings” has no tax liability under section 4943.
Likewise, section 49449 is a regulatory tax rather than a revenue-raising measure. Section 4944 applies if a private foundation retains any assets that “jeopardize” the foundation in the “carrying out of any of its exempt purposes.” This statutory admonition is understood to require private foundations to invest their respective assets prudently.10 As long as a foundation’s holdings are prudent, no tax is due. Section 4944 thus polices compliance with the investment standard of prudence. In a perfect world, section 4944 would generate no revenue because every private foundation would comply with that standard.
Finally, section 494511 identifies as “taxable expenditure[s]” five types of outlays it deems inappropriate for private foundations. These proscribed outlays are (1) foundation payments that “carry on propaganda, or otherwise . . . attempt, to influence legislation”;12 (2) expenditures designed “to influence the outcome of any specific public election, or to carry on, directly or indirectly, any voter registration drive”13 unless those outlays meet specified criteria to guarantee their nonpartisan nature;14 (3) grants to individuals “for travel, study, or similar purposes” unless those grants meet specific substantive and procedural tests;15 (4) distributions to organizations other than public charities or exempt operating foundations unless the donating foundation “exercise(s) expenditure responsibility” regarding those distributions;16 and (5) any grant “for any purpose other than one” justifying the private foundation’s tax-exempt purpose.17
Again, section 4945 is a regulatory, rather than a revenue-raising, measure. A private foundation that makes no “taxable expenditure” owes no tax under this section.
In contrast to these regulatory taxes,18 section 494019 is a revenue-generating measure. Under that provision, a private foundation20 automatically pays 1.39 percent of the foundation’s annual investment income to the federal treasury.21 No good behavior (like avoiding self-dealing transactions or eschewing imprudent investments) enables a foundation to avoid the section 4940 tax. No bad behavior triggers this tax. Section 4940 requires a yearly payment to the federal fisc from each private foundation’s investment income.
Three reasons suggest why private foundations contribute in this fashion to the treasury under section 4940:
First: They can. Ability to pay is a traditional criterion of tax policy.22 A private foundation’s investment income enables that foundation to pay tax.
Second: Private foundations, like other taxpayers, benefit from the social overhead provided by the federal government. Benefits received is also a traditional lodestar of tax policy.23
Third (and perhaps most controversially): Private foundations resemble corporations that pay federal income taxes.24 For reasons of equity and efficiency, similar persons should be taxed similarly. Section 4940 extends to private foundations the popular and political consensus that well-capitalized, corporate-style organizations should be taxed to support public overhead.
These rationales for taxing private foundations — ability to pay, benefits received, corporate resemblance — suggest that all charitable endowments should contribute to the federal treasury as private foundations do under section 4940. Charitable endowments have the same ability to pay as private foundations, receive the same public benefits, and have the same corporate-like attributes. By extending the policy of section 4940 to some large educational endowments, section 4968 moved the IRC in the desirable direction of extending revenue-generating taxation to the universe of charitable endowments. This extension will improve the fairness and efficiency of the code by taxing similar institutions — private foundations, community foundations, educational endowments, donor-advised funds — similarly.
Section 4968 and BBBA Section 137702
Section 4968, modeled on section 4940, imposes an annual tax of 1.4 percent on the net investment incomes of any “applicable educational institution.”25 A college or university is such an institution if it is private,26 “had at least 500 tuition-paying students during the preceding taxable year,”27 has more than half of those tuition-paying students in the United States,28 and holds investment assets of more than “$500,000 per student.”29
While discussion concerning the adoption of section 4968 has often criticized the tuition levels and scholarship practices of many endowed colleges and universities,30 as adopted, section 4968 does not regulate that tuition or scholarships. If Harvard radically increases its scholarship payments, it will still owe the same tax under section 4968 as before. Section 4968, tracking the terms of section 4940, raises revenue rather than regulating behavior.
Section 137702 of the BBBA would change that.31 It would transform IRC section 4968 from a revenue-raising measure like section 4940 into a regulatory tax like sections 4941 through 4945. Central to this transformation of section 4968 would be a new formula designed to decrease and ultimately eliminate that section’s tax as schools expand their scholarship assistance. The first step of this formula would be determining the school’s financial assistance for tuition and fees for its “first-time, full-time undergraduate students.”32 The proposed statutory formula would then calculate the excess of this assistance over 20 percent of the aggregate tuition and fees paid by those students.33 In the third step, this excess would be compared with 13 percent of the total undergraduate tuition and fees received by the school.34 Finally, the resulting ratio would reduce (and sometimes eliminate) the section 4968 tax owed by the school on its NII if the school’s scholarship assistance were high enough.35
To illustrate the operation of this proposed statutory formula and its transformation of section 4968 from a revenue-raising tax to a regulatory measure, consider three hypothetical examples of colleges with different scholarship practices. All three of these theoretical colleges trigger section 4968’s tax on NII. Each of them receives $50 million in total tuition and fee payments from undergraduates. However, these three otherwise identical schools provide their students with different levels of scholarship assistance. College A awards $10 million in annual assistance to first-time, full-time undergraduates. Because College A’s total scholarship assistance of $10 million exactly equals 20 percent of the $50 million in tuition and fees this school receives from its undergraduates, there would be no excess to reduce the college’s tax obligation under section 4968 as amended by section 137702. At that point, the inquiry under the proposed statutory formula would stop.
College B, on the other hand, awards its first-time, full-time undergraduates more scholarship assistance, $14 million annually. For College B, scholarship assistance of $14 million exceeds by $4 million the amount that is 20 percent of total tuition and fees paid by undergraduates ($10 million). Hence, College B would go to the next step of the proposed statutory formula and would compare that excess of $4 million with the amount that is 13 percent of the total tuition and fees paid by undergraduates. Because 13 percent of $50 million is $6.5 million, the ratio under the proposed statute would be 4:6.5.36 Consequently, because College B awards more undergraduate scholarships than College A, College B’s net tax obligation under amended section 4968 would be reduced by 62 percent.37
College C awards its first-time, full-time undergraduates the most assistance, $18 million in tuition scholarship annually. For College C, scholarships of $18 million exceed by $8 million the amount that is 20 percent of the total tuition and fees paid by undergraduates ($10 million). Hence, College C, like College B, would go to the next step of the proposed formula and would compare the excess of $8 million with an amount that is 13 percent of the total tuition and fees paid by undergraduates. Because 13 percent of $50 million is $6.5 million, the relevant ratio would be 8:6.5.38 Because this ratio exceeds 1, College C’s tax would be eliminated under amended section 4968.
The formula to be added to IRC section 4968 by BBBA section 137702 would thus transform the tax levied by section 4968 from a revenue measure (College C no longer pays anything) to a tax that regulates scholarship assistance: More scholarships would reduce and sometimes eliminate the tax imposed by section 4968 as modified by section 137702.
Preserving and Extending Section 4968
The regulation of schools’ scholarship practices may or may not be desirable, but that regulation should be pursued separately from section 4968. The code provides many examples of regulatory taxation.39 Any of these examples could provide a model to be emulated by those seeking to control schools’ scholarship practices.
In contrast to BBBA section 137702, IRC section 4968 should be modified to extend its tax on NII to all colleges and universities and, ultimately, all charitable endowments including community foundations and donor-advised funds.
The case for preserving and extending section 4968 rests on venerable principles of tax policy: College and university endowments have the capacity to pay. They benefit from public services. Their endowments are large agglomerations of capital held in corporate-like institutions. In the interests of equity and efficiency, similar entities should be taxed similarly.
TRA 69 added section 4940 to the IRC and its revenue-raising tax on private foundations’ NII. Section 4940 is now an established and accepted part of the federal tax law. Starting with that section and its tax as a baseline, economically similar institutions should be taxed similarly to private foundations.
Consider donor-advised funds, which are proliferating as functional equivalents of private foundations.40 In 1969 donor-advised funds did not exist as they do today. The Congress that focused on private foundations in TRA 69 would likely have recognized donor-advised funds as functionally identical to private foundations. If it is sensible for those foundations to contribute to the federal fisc as they have for over five decades, donor-advised funds should contribute also. Donor-advised funds have the same ability to pay as private foundations, use the same public services as those foundations, and constitute the same kind of corporate-like capital aggregations as private foundations. In the interests of equity and efficiency, section 4940 and its revenue-generating tax should be extended to donor-advised funds because these funds are functionally identical to private foundations.
Donor-advised funds are often sponsored by community foundations.41 If I am correct that donor-advised funds are so closely analogous to private foundations that they should be taxed for revenue as private foundations are, the next analogy is between donor-advised funds and the other investments held by community foundations. Considering capacity to pay, public benefits received, and corporate resemblance, community foundations are comparable to private foundations and donor-advised funds and should similarly be called on to contribute to the federal fisc.
It is then a short step from community foundations to educational and other charitable endowments.42 In this context, section 4968, by taxing some schools’ endowments like private foundations, is a modest step toward the eventual extension to all endowments of the taxation that TRA 69 imposed on private foundations through section 4940.
Conclusion
However well-meaning the advocates of the BBBA’s section 137702 may be, they have picked the wrong vehicle for regulating college and university scholarship practices. Section 4968 should remain intact as the initial extension beyond private foundations of the revenue taxation imposed by section 4940. Section 4968 should not be converted into a regulatory measure. Section 4968 and its revenue-raising tax should instead be extended to all educational endowments and, eventually, all charitable endowments.
FOOTNOTES
4 Edward A. Zelinsky, “The Taxation of Charitable Endowments’ Investment Incomes,” Tax Notes Federal, Jan. 20, 2020, p. 401; Zelinsky, “Section 4968 and Taxing All Charitable Endowments: A Critique and a Proposal,” 38 Va. Tax. Rev. 141 (2018).
5 Section 4941. For a detailed analysis of section 4941, see Ellen P. Aprill, “The Private Foundation Excise Tax on Self-Dealing: Contours, Comparisons, and Character,” 17 Pitt. Tax Rev. 297 (2020).
6 Section 4942. For a detailed analysis of section 4942, see Ray D. Madoff, “The Five Percent Fig Leaf,” 17 Pitt. Tax Rev. 341 (2020).
7 Section 4943. For a discussion of section 4943, see Dana Brakman Reiser, “Disruptive Philanthropy: Chan-Zuckerberg, the Limited Liability Company, and the Millionaire Next Door,” 70 Fla. L. Rev. 921, 933-937 (2018).
8 Zelinsky, “Saving Butch Cassidy’s Charitable Legacy,” OUPblog (Feb. 12, 2018).
9 Section 4944. See Reiser, supra note 7, at 937-939.
10 Reg. section 53.4944-1(a)(2)(i).
15 Section 4945(d)(3) and (g).
16 Section 4945(d)(4) and (h).
18 And in contrast to the other regulatory taxes imposed by the IRC, see, e.g., sections 4971 through 4980H (regulatory excise taxes imposed on qualified retirement plans and fringe benefit arrangements).
19 Section 4940. Section 4940 does not apply to some “operating” foundations. Section 4940(d). If, as I suggest, revenue-generating taxation should be extended to all charitable endowments, this exemption for operating foundations should be eliminated as well.
20 On the definition of a private foundation, see Zelinsky, “A Response to the Initiative to Accelerate Charitable Giving,” Tax Notes Federal, Feb. 1, 2021, p. 755, 756-758; Daniel N. Belin, Charitable Foundations: The Essential Guide to Giving and Compliance 11-12 (2015); Brian Galle, “The Quick (Spending) and the Dead: The Agency Costs of Forever Philanthropy,” 74 Vand. L. Rev. 757, 766-767 (2021); and Lloyd Hitoshi Mayer, “The ‘Independent’ Sector: Fee-for-Service Charity and the Limits of Autonomy,” 65 Vand. L. Rev. 51, 87 (2012).
22 Joseph Bankman et al., Federal Income Taxation 50-51 (2019).
23 Louis Kaplow, The Theory of Taxation and Public Economics 209-211 (2008).
24 Zelinsky, “Section 4968 and Taxing All Charitable Endowments,” supra note 4, at 166-170.
25 Section 4968(a). For a more critical perspective on section 4968, see James J. Fishman, “How Big Is Too Big: Should Certain Higher Educational Endowments’ Net Investment Income Be Subject to Tax?” 28 Cornell J.L. & Pub. Pol’y 159 (2018); and George F. Will, American Happiness and Discontents 237-238 (2021).
30 Fishman, supra note 25, at 172-173, 189; Janet Lorin, “Universities Seek to Defend Endowments From Republican Tax Plan,” Bloomberg, Apr. 18, 2017; Brook Jackling, “College Works Against New Endowment Bill,” The Dartmouth, Oct. 31, 2007 (”Dartmouth is preparing to lobby against the September legislative proposal made by Sen. Chuck Grassley, R-Iowa, that would require U.S. universities to spend more of their endowments in an attempt [to] increase financial aid awards. The proposed legislation would force colleges with endowments greater than $500 million to spend 5 percent of their endowments annually.”).
31 Section 137702 would also amend section 4968 by adjusting for inflation the $500,000-per-student standard of section 4968(b)(1)(D) and by providing that the 500-student threshold of section 4968(b)(1)(A) would only count undergraduates. See section 137702(b) and section 137702(c).
32 Section 137702(a) (adding section 4968(e)(1)(A)(i) to the IRC).
33 Id. (adding section 4968(e)(1)(A)(ii) to the IRC).
34 Id. (adding section 4968(e)(1)(B) to the IRC).
35 Id. (adding section 4968(e)(1) to the IRC). Section 137702 would condition the formula-based abatement of the section 4968 tax on the school disclosing data about student loans. Section 137702(a) (adding section 4968(e)(2) to the IRC).
36 I.e., $4 million: $6.5 million.
37 4/6.5 = 62 percent.
38 I.e., $8 million: $6.5 million.
39 See notes 6 through 19, inclusive, supra and accompanying text.
40 On the rise of donor-advised funds, see Samuel D. Brunson, “‘I’d Gladly Pay You Tuesday for a (Tax Deduction) Today’: Donor-Advised Funds and the Deferral of Charity,” 55 Wake Forest L. Rev. 245, 258-272 (2020).
41 See, e.g., Fairfield County’s Community Foundation, “Donor Advised Funds.”
42 Professor Jennifer Bird-Pollan suggests another analogy, that college and university endowments increasingly resemble private equity funds and thus should be taxed like them. Bird-Pollan, “Taxing the Ivory Tower: Evaluating the Excise Tax on University Endowments,” 48 Pepp. L. Rev. 1055, 1083 (2021).
END FOOTNOTES